Being young and having the ability to save for retirement is a privilege. A lot of young professionals are faced with the task of building a 401k that will help them live comfortably in forty years or so. Investing in long term growth and building a portfolio goes far beyond picking “hot stocks” and undervalued securities. In this article, I give young professionals like myself three tips that will help them decide what retirement funds to invest in.
1. Go for high growth, but not high leverage
Being young, we have the ability to take a few risks. We have plenty of time until we retire and if something goes wrong, we have a good chance of bouncing back or building a decent nest egg from scratch. As inflation and our developing careers lower our value of a dollar, a small percentage of our salary today will be negligibly small in the distant future, unless it has a high growth rate. However, gaining this high growth through leverage is a bad idea, because if a leveraged security or fund goes bad, you risk hitting absolute zero. In a very long term investment the odds of a leveraged investment losing completely get pretty high. Find investments that can grow quickly but have little risk of total price collapse like the developing world and raw materials. iShares Emerging Markets (EEM) and the Materials SPDR (XLB) are good examples of ETFs that can accomplish this.
2. Hedge against risk factors
There are several market risk factors that can drastically affect the values of certain assets. For example, if there is an increase in inflation or interest rates, the value of bonds decreases. An increase in raw materials prices will hurt the value of industrial stocks. There are several economic variables that will determine how much money you will need to retire. Hedging against these economic variables will increase the value of your portfolio in situations where you may need your retirement money more. If commodity prices stay low and raw materials prices decrease over the next forty years, you are less likely to need a large nest egg. Think about the future value of the positions you hold in different economic conditions. There should be a lot of value in a tough economic environment and a moderate amount of value in a less hostile economy so you have a better chance of having the money you will need. The iShares Barclays TIPS Bond Fund (TIP) is an ETF that hedges against the risk of inflation and is a good example of a security that protects against economic risk factors.
It is important to invest in a wide range of different asset classes in the likely event that a particular asset class becomes worth much less or becomes obsolete. I love REITs, but if interest rates spike and credit freezes up, a 401k full of REIT holdings will become worthless. Diversification means having a 401k with a manageable amount of funds, but also the ability to cover most areas of the world market. Diversification also means that you should not invest substantially in the company you work for. If your company experiences a crisis, you could not only lose your job but also your life savings, which can financially cripple anybody. You already hold a large stake in your employer and no matter how undervalued their stock is, you should invest most of your retirement in funds not related to your company. The employees of Lehman Brothers owned 30 percent of their company and now many of them are in very bad financial situations after a long career of hard work. Investing in SPY, the S&P 500 ETF instead of a handful particular stocks is an example of diversification.